Road to Hyperinflation is paved with Market Accommodating Monetary Policy

By
Henry C.K. Liu

Part I: A Crisis the Fed Helped to Create but Helpless to Cure http://www.henryckliu.com/page151.html


This article appeared in AToL on January 26, 2008

After months of denial to sooth a nervous market, the Federal Reserve, the US central bank, finally started to take increasingly desperate steps in a series of frantic attempts to try to inject more liquidity into distressed financial institutions to revive and stabilize credit markets that have been roiled by turmoil since August 2007 and to prevent the home mortgage credit crisis from infesting the whole economy. Yet more liquidity appears to be a counterproductive response to a credit crisis that has been caused by years of excess liquidity. A liquidity crisis is merely a symptom of the current financial malaise. The real disease is mounting insolvency resulting from excessive debt for which adding liquidity can only postpone the day of reckoning towards a bigger problem but cannot cure. Further, the market is stalled by a liquidity crunch, but the economy is plagued with excess liquidity. What the Fed appears to be doing is to try to save the market at the expense of the economy by adding more liquidity.

The Federal Reserve has at its disposal three tools of monetary policy: open market operations to keep fed funds rate on target, the discount rate and bank reserve requirements. The Board of Governors of the Federal Reserve System is responsible for setting the discount rate at which banks can borrow directly from the Fed and for setting bank reserve requirements. The Federal Open Market Committee (FOMC) is responsible for setting the fed funds rate target and for conducting open market operations to keep it within target. Interest rates affects the cost of money and the bank reserve requirements affect the size of the money supply.

The FOMC has twelve members--the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. The FOMC holds eight regularly scheduled meetings per year to review economic and financial conditions, determine the appropriate stance of monetary policy, and assess the risks to its long-run goals of price stability and sustainable economic growth. Special meetings can be called by the Fed Chairman as needed.

Using these three policy tools, the Federal Reserve can influence the demand for, and supply of balances that depository institutions hold at Federal Reserve Banks and in this way can alter the federal funds rate target, which is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. Changes in the federal funds rate trigger a chain of effects on other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and market prices of goods and services.

Yet the effects of changes in the fed funds rate on economic variables are not static nor are they well understood or predictable since the economy is always evolving into new structural relationships among key components driven by changing economic, social and political conditions. For example, the current credit crisis has evolved from the unregulated global growth of structured finance with the pricing of risk distorted by complex hedging which can fail under conditions of distress. The proliferation of new market participants such as hedge funds operating with high leverage on complex trading strategies has exacerbated volatility that changes market behavior and masked heightened risk levels in recent years. The hedging against risk for individual market participants has actually increased an accumulative effect on systemic risk.

The discount window is designed to function as a safety valve in relieving pressures in interbank reserve markets. Extensions of discount credit can help relieve liquidity strains in individual depository institutions and in the banking system as a whole. The discount window also helps ensure the basic stability of the payment system more generally by supplying liquidity during times of systemic stress. Yet the discount window can have little effect when a liquidity drought is the symptom rather than the cause of systemic stress.

Banks in temporary distress can borrow short term funds directly from a Federal Reserve Bank discount window at the discount rate, set since January 9, 2003 at 100 basis points above the fed funds rate. Prior to that date, the discount rate was set below the target fed funds rate to provide help to distressed banks but a stigma was attached to discount window borrowing.  Healthy banks would pay 50 to 75 basis points in the money market rather than going to the Fed discount widow, complicating the Fed’s task in keeping the fed funds rate on target. Part of the reason for raising the discount rate 100 basis point above the fed funds rate on January 9, 2003 was to remove this stigma that had kept many banks from using the Fed discount window. For a historical account of the change of the discount rate, see my August 24, 2007 article: Central Bank Impotence and Market Liquidity.

Both the discount rate and the fed funds rate are set by the Fed as a matter of policy. On August 17, 2007, the discount window primary credit program was temporarily changed to allow primary credit loans for terms of up to 30 days, rather than overnight or for very short terms as before. Also, the spread of the primary credit rate over the FOMC’s target federal funds rate has been reduced to 50 basis points from its customary 100 basis points. These changes will remain until the Federal Reserve determines that market liquidity has improved. The Fed keeps the fed funds rate within narrow range of its target through FOMC trading of government securities in the repo market.

A repurchase agreement (repo) is a loan, often for as short as overnight, typically backed by top-rated US Treasury, agency, or mortgage-backed securities. Repos are contracts for the sale and future repurchase of top-rated financial assets. It is through the repo market that the Fed injects funds into or withdraws funds from the money market, raising or lowering overnight interest rates to the level set by the Fed. See my September 29, 2005 article in AToL: THE WIZARD OF BUBBLELAND - PART II: The Repo Time Bomb.

Until the regular FOMC meeting scheduled for January 29, 2008, the discount rate had been expected to stay at 4.75% while the Fed Funds target would stay at 4.25%, with a 50 basis points spread, half of normal, which had been set at a spread of 100 basis points since January 9, 2003. From a high of 6% set on May 18, 2000, the Fed had lowered the discount rate in 12 steps to 0.75% by November 7, 2002 and kept it there until January 8, 2003 while the Fed Funds rate target was set at 1.25%, 50 basis points above. On January 9, 2003, the discount rate was set 100 basis points above the Fed Funds rate target. Then the Fed gradually raised the discount rate back up to 6% by May 10, 2006 and again to 6.25% on June 29, 2006. On August 18, 2007, in response to the sudden outbreak of the credit market crisis, the Fed panicked and dropped the discount rate 50 basis points to 5.75%, and continued lowering it down to the current level of 4.75% set on December 12, 2007.

On Monday, January 21, a week before the scheduled FOMC meeting, global equities plunged as investor concerns over the economic outlook and financial market turbulence snowballed into a sweeping sell-off. Tumbling Asian shares – which continued to fall early on Tuesday – led European stock markets into their biggest one-day fall since the 9/11 terrorist attacks of 2001 as the prospect of a US recession and further fall-out from credit market turmoil prompted near panic among investors, forcing them to rush to the safety of government bonds.

Some $490 billion was wiped off the market value of Europe’s FTSE Eurofirst 300 index and $148 billion from the FTSE 100 index in London, which suffered its biggest points slide since it was formed in 1983. Germany’s Xetra Dax slumped 7.2% to 6,790.19 and France’s CAC-40 fell 6.8% to 4,744.45, its worst one-day percentage point fall since September 11 2001.  The price collapse was driven by general negative sentiments and not by any one identifiable event.

The Fed Tries in vain to Save the Market by Risking Hyperinflation

After being closed on Monday for the Martin Luther King holiday, US stock benchmarks echoed foreign markets with big declines, extending large losses from the previous week, with bearish sentiments accelerated by heavy selling across global markets. About an hour before the NY stock Exchange open on Tuesday, the Federal Reserve announced a cut of 75 basis points of the fed funds rate target to 3.50%, the first time that the Fed has changed rates between meetings since 2001, when the central bank was battling the combined impacts of a recession and the terrorist attacks.

Fed officials decided on their move at a videoconference at 6pm US time on Monday, January 21, with one policymaker – Bill Poole [I have a special interest in Bill, since he was a classmate of mine. Well, actually, he was in the class ahead of me, I think.], the president of the St Louis Fed, dissenting. In a statement, the Fed said it acted “in view of a weakening of the economic outlook and increased downside risks to growth.” It said that while strains in short-term money markets had eased, “broader financial conditions have continued to deteriorate and credit has tightened further for some businesses and households.” And new information also indicated a “deepening of the housing contraction” and “some softening in labor markets.” The Fed pledged to act in a “timely manner as needed” to address the risks to growth, implying that it expects to cut the federal funds rate rates still further, and will consider doing so at its scheduled policy meeting on January 30.

In overnight trade, Asian shares extended their losses. Japan’s Nikkei 225 index accumulated its worst two-day decline in nearly two decades, losing more than 5% and falling below 13,000 for the first time since September 2005.

Initially, the Fed move caused S&P stock futures to jump but within half an hour they were lower than they had been at the moment the rate cut was announced. The Dow Jones industrial average, down 465 points shortly after market open, fluctuated throughout the day before closing with a milder drop of 126.24, or 1.04%, at 11,973.06, the first closing below 12,000 since November 3, 2006.

The move was the first unscheduled Fed rate cut since September 17, 2001 and its largest increment since regular meetings began in 1994. It was a sharp departure from traditional gradualism preferred by the Fed and wild volatility in the market can be expected as a result.  S&P equity volatility as measured by the Vix index surged 38%, eclipsing the high set in August when the credit crisis first surfaced.

The aggressive Fed action triggered a rebound in European stock markets, but was not enough to stop the US equity market – which had been closed when markets fell globally on Monday – from trading lower. At midday the S&P 500 index was at 1,302.24 down 1.7 per cent on the day and 11.3 per cent so far this year amid mounting concern over the prospect of a recession and further credit market turmoil. While financial stocks had rebounded 1.8% in morning trading, other main sectors were sharply lower, by a 3.4% decline in technology shares.

While the Fed has the power to independently set the discount rate directly and keep the Fed funds rate on target indirectly through open market operations, the impact of short-term rates on monetary policy implementation has been diluted by long-term rates set separately by deregulated global market forces. When long-term rates fall below short-term rate, the inverted rate curve usually suggests future economic contraction.

Both discount and fed funds loans are required to be collateralized by top-rated securities. Since August 2007, the Fed has been faced with the problem of encouraging distressed banks to borrow from the Fed discount window without suffering the usual stigma of distress, accepting as collateral bank holdings of technically still top-rated collateralized debt obligations (CDOs) which in reality have been impaired by their tie to subprime home mortgage debt obligations that have lost both marketability and value in a credit market seizure.

As economist Hyman Minsky (1919-1996) observed insightfully, money is created whenever credit is issued. The corollary is that money is destroyed when debts are not paid back. That is why home mortgage defaults create liquidity crises. This simple insight demolishes the myth that the central bank is the sole controller of a nation’s money supply. While the Federal Reserve commands a monopoly on the issuance of the nation’s currency in the form of Federal Reserve notes, which are “legal tender for all debts public and private”, it does not command a monopoly on the creation of money in the economy.

The Fed does, however, control the supply of “high power money” in the regulated partial reserve banking system. By adjusting the required level of reserves and by injecting high power money directly into the banking system, the Fed can increase or decrease the ability of banks create money by lending the same money to customers in multiple times, less the amount of reserves each time, relaying liquidity to the market in multiple amounts because of the mathematics of partial reserve. Thus with 10% reserve requirement, a $1,000 initial deposit can be loaned out 45 times less 10% reserve withheld each time to create $7,395 of loans and an equal amount of deposits from borrowers.

But money can be and is created by all debt issuers, public and private, in the money markets, many of which are not strictly regulated by government. While a predominant amount of global debt is denominated in dollars, on which the Fed has monopolistic authority, the notional value used in structured finance denominated in dollars, which reached a record $681 trillion in third quarter 2007, is totally outside the control of the Fed. Virtual money is largely unregulated, with the dollar acting merely as an accounting unit. When US homeowners default on their mortgages en mass, they destroy money faster than the Fed can replace it through normal channels. The result is a liquidity crisis which deflates asset prices and reduces monetized wealth.

As the debt securitization market collapses, banks cannot roll over their off-balance sheet liabilities by selling new securities and are forced to put the liabilities back on their own balance sheets. This puts stress on bank capital requirements. Since the volume of debt securitization is geometrically larger than bank deposits, a widespread inability to roll over short term debt securities will threaten banks with insolvency.

The Fed Can Create Money but Not Wealth 

Money is not wealth. It is only a measurement of wealth. A given amount of money, qualified by the value of money as expressed in its purchasing power, represents an account of wealth at a given point in time in an operating market. Given a fixed amount of wealth, the value of money is inversely proportional to the amount of money the asset commands: the higher the asset price in money terms, the less valuable the money. When debt pushes asset prices up, it in effect pushes the value of money down in terms of purchasing power. In an inflationary environment, when prices are kept high by excess liquidity, monetized wealth stored in the underlying asset actually shrinks. This is the reason why hyperinflation destroys monetized wealth.

When the central bank withdraws money from the market by selling government securities, it in essence reduces sovereign credit outstanding because a central bank never needs borrow its own currency which it can issue at will, the only constraint being impact on inflation, which can become a destroyer of monetized wealth when inflation is tolerated not as a stimulant for growth but merely to prop up an overpriced market in a stagnant economy.

Yet debt can only be issued if there are ready lenders and borrowers in the credit market. And the central bank is designed to serve as “lender of last resort” when lenders become temporarily scarce in credit markets. But when borrowers are scarce not due to short-term cash flow problems but because either due to low credit rating or insufficient borrower income to service debts, the central bank has no power to be a “borrower of last resort”.

The Federal Government is the Borrower of Last Resort

The role of “borrower of last resort” belongs to the Federal Government, as Keynes observed when he advocated government deficit spending to moderate business cycles. The Bush administration, through the Treasury, sells sovereign bonds to finance a hefty fiscal deficit. The only problem is that it spends both taxpayer money and proceeds from sovereign bonds mostly on wars overseas, leaving the domestic economy in a liquidity crisis.

To address an impending recession, the Bush 2008 proposal of a $150 billion stimulus package of tax relief, representing 1% of GDP, would target $100 billion to individual taxpayers and about $50 billion toward businesses. Economists said a reasonable range for tax cuts in the package might be $500 to $1,000 per tax payer, averaging $800. Bush said the income tax relief “would help Americans meet monthly bills and pay for higher gas prices.” The policy objective is to keep consumers spending to stimulate the slowing economy, as consumer spending accounts for about 70% of the US economy.

Speaking after the president, Secretary of the Treasury Henry Paulson said he was confident of long-term economic strength, but that “the short-term risks are clearly to the downside, and the potential cost of not acting has become too high.” He added that 1% of GDP would equate $140 billion to $150 billion, which is along the lines of what private economists say should be sufficient to help give the economy a short-term boost.

“There’s no silver bullet,” Paulson said, “but, there’s plenty of evidence that if you give people money quickly, they will spend it.”

Yet the Republican proposal favors a tax rebate, meaning that only those who actually paid taxes would get a refund. That means a family of four with an annual income of $24,000 would receive nothing and only those with annual income of over $100,000 would get the full $800 rebate per taxpayer, or $1,600 for joint return households.

Further, against a total US consumer debt (which includes installment debt, but not home mortgage debt) of $2.46 trillion in June 2007, which came to $19,220 per tax payer, the Bush rebate of $800 would not be much relief even in the short term. In 2007, US households owed an average of $112,043 for mortgages, car loans, credit cards and all other debt combined.  Outstanding credit default swaps is around $45 trillion, which is 3 times larger than US GDP of $15 trillion and 300 times larger than the Bush relief plan of $150 billion.

Bush did not push for a permanent extension of his 2001 and 2003 tax cuts, many of which are due to expire in 2010, eliminating a potential stumbling block to swift action by Congress, since most the controlling Democrats oppose making the tax cuts permanent. The 2008 tax relief proposal harks back to the Bush 2001 and 2003 tax cuts, which were at variance with established principles that an effective tax stimulus package needs to maximize the extent to which it directly stimulates new economic activity in the short-term and minimize the extent to which it indirectly restrains new activity by driving up interest rates. The Bush tax cuts were implemented without first adopting an overall stimulus budget; nor designing business incentives to provide incentives for new investment, rather than windfalls for old investment; nor designing household tax cuts to maximize the effects on short-term spending; nor focusing on temporary (one-year) items for businesses and households, not permanent ones. Most significant of all, they failed to maintain long-term fiscal discipline.

The flawed 2001 Bush tax stimulus package included five items: 1) A permanent tax subsidy (through partial expensing) of business investment; 2) permanent elimination of the corporate alternative minimum tax; 3) permanent changes in the rules applying to net operating loss carry-backs; 4) acceleration of some of the personal income tax reductions scheduled for 2004 and 2006 and 5) a temporary household tax rebate aimed at lower- and moderate-income workers who actually paid income taxes, a condition that reduced its effectiveness. The 2001 Bush tax stimulus package included permanent changes that were less effective at stimulating the economy in the short run than temporary changes but more expensive. And its acceleration of the recently enacted tax cuts for higher-income taxpayers was poorly targeted and potentially counter-productive. A more effective stimulus package would combine the household rebate aimed at lower- and moderate-income workers with a temporary incentive for business investment.  Yet for the last two decades, even in boom time, the US middle class has not been receiving its fair share of income, while increasingly bearing a larger share of public expenditure. The long-term trend of income disparity is not being addressed by the bipartisan short-term stimulus package.

War Costs

The Congressional Research Service (CRS) report, updated November 9 2007, shows that with enactment of the FY2007 supplemental on May 25, 2007, Congress has approved a total of about $609 billion for military operations, base security, reconstruction, foreign aid, embassy costs, and veterans’ health care for the three operations initiated since the 9/11 attacks: Operation Enduring Freedom (OEF) Afghanistan and other counter terror operations; Operation Noble Eagle (ONE), providing enhanced security at military bases; and Operation Iraqi Freedom (OIF).  A 2006 study by Columbia University economist Joseph E. Stiglitz, the 2001 Nobel laureate in economics, and Harvard professor Linda Bilmes, leading expert in US budgeting and public finance and former Assistant Secretary and Chief Financial Officer of the US Department of Commerce, concluded that the total costs of the Iraq war could top $2 trillion.

Greenspan Sees No Fed Cure

Alan Greenspan, the former Fed Chairman, wrote in a defensive article in the December 12, 2007 edition of the Wall Street Journal: “In theory, central banks can expand their balance sheets without limit. In practice, they are constrained by the potential inflationary impact of their actions. The ability of central banks and their governments to join with the International Monetary Fund in broad-based currency stabilization is arguably long since gone. More generally, global forces, combined with lower international trade barriers, have diminished the scope of national governments to affect the paths of their economies.” In exoteric [less esoteric?] language, Greenspan is saying that short of moving towards hyperinflation, central banks have no cure for a collapsed debt bubble.

Greenspan then gives his prognosis: “The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated and home price deflation comes to an end. … … Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the US economy, and the global economy more generally, will be able to get back to business.”

Greenspan did not specify whether “getting back to business” as usual means onto another bigger debt bubble as he had repeatedly engineered during his 18-year-long tenure at the Fed. Greenspan is advocating first a manageable amount of pain to moderate moral hazard, then massive liquidity injection to start a bigger bubble to get back to business as usual. What Greenspan fails to understand, or at least to acknowledge openly, is that the current housing crisis is not caused by an oversupply of homes in relation to demographic trends. The cause lies in the astronomical rise in home prices fueled by the debt bubble created by an excess of cheap money.

Home Mortgage Crisis Spills Over to Corporate Debt Crisis

Many homeowners with zero or even negative home equity cannot afford the reset high payments of their mortgages with their current income which has been rising at a much slower rate than their house payments. And as housing mortgage defaults mount, the liquidity crisis deepens from money being destroyed at a rapid rate, which in turn leads to counterparty defaults in the $45 trillion of outstanding credit swaps (CDS) and collateralized loan obligations (CLO) backed by corporate loans that destroy even more money, which will in turn lead to corporate loan defaults.

Proposed government plans to bail out distressed home owners can slow down the destruction of money, but it would shift the destruction of money as expressed by falling home prices to the destruction of wealth through inflation masking falling home value.

Credit Insurer Crisis

Credit insurers such as MBIA, the world’s largest financial guarantor whose shares have dropped 81% in 2007 from a high of $73 to $13, are on the brink of bankruptcy from its deteriorating capital position in light of rating agencies reviews of residential mortgage-backed securities and collateralized debt obligations that have been insured by MBIA that are expected to stress its claims-paying ability.  On December 10, 2007, MBIA received a $1 billion boost to its cash reserves from private equity firm Warburg Pincus in an effort to protect its credit rating. By January 10, 2008, MBIA announced it would try to raise another $1 billion in “surplus notes” at 12% yield. The next day, traders reported that the deal was facing problems attracting investor and might have to raise the yield to 15%. But Bill Ackman of Pershing Square Capital Management told Bloomberg that regulators can be expected to block payment to surplus note holders. Further, raising enough new capital to retain credit rating would so dilute existing shareholder value as to remove all incentive to save the enterprise. 

Maintaining AAA credit rating is of utmost important to bond insurers like MBIA because it needs a strong credit rating in order to guarantee debt. Moody’s, Standard & Poor’s and Fitch are all reviewing the financial strength ratings of bond insurers, which write insurance policies and other contracts protecting lenders from defaults.

For the insurers to maintain the necessary triple-A rating, their capital reserve would have to be repeatedly increased along the premium they charge.  There will soon come a time when insurance premium will be so high as to deter bond investors. Already, the annual cost of insuring $10 million of debt against Bear Stern defaulting has risen from $40,000 in January 2007 to $234,000 by January of 2008. To buy credit default insurance on $10 million of debt issued by Countrywide, the big subprime mortgage lender, investor must as of January 11, 2008 pay $3 million up front and $500,000 annually. A month ago, the same protection could be bought at $776,000 annually with no upfront payment.

Credit Default Swaps

Credit-default swaps tied to MBIA's bonds soared 10 percentage points to 26% upfront and 5% a year, according to CMA Datavision in New York. The price implies that traders are pricing in a 71% chance that MBIA will default in the next five years, according to a JPMorgan Chase & Co. valuation model. Contracts on Ambac, the second-biggest insurer, rose 12 percentage points to 27% upfront and 5% a year. Ambac’s implied chance of default is 73%.

MBIA and competitors such as Ambac Financial and ACA Capital insure mortgage-backed securitized debt and bonds, which came under pressure as the subprime fallout all but wiped out mortgage credit. The credit ratings agencies have since tried to determine whether bond insurers’ ability to pay claims against a sudden rise in defaulted debt has been impacted by the deterioration of the home mortgage market.  A ratings downgrade has broad fallout, causing billions of bonds insured by the firms to also lose value. Banks have been major buyers of debt insurance on the bonds they hold.

MBIA is also facing a series of class action suits for misrepresenting and/or failing to disclose the true extent of MBIA exposure to losses stemming from its insurance of residential mortgage-backed securities (RMBS), including in particular its exposure to so-called "CDO-squared" securities that are backed by RMBS. Other class action suits involve alleged violation of the Employee Retirement Income Security Act of 1974 (ERISA) relating to MBIA 401(k) plan.

Synthetic CDO-squared are double layer collateralized debt obligations that offer investors higher spreads than single-layer CDO but also may present additional risks. Their two-layer structures somewhat increase their exposure to certain risks by creating performance “cliffs” that cause seemingly small changes in the performance of underlying reference credits to produce larger changes in the performance of a CDO-squared. If the actual performance of the reference credits deviates substantially from the original modeling assumptions, the CDO-squared can suffer unexpected losses. On January 11, MBIA announced in a public filing it has $9 billion of exposure to the riskiest structures known as CDO of CDO, or CDO-squared, $900 million more than the company disclosed only three weeks ago. MBIA also said it now has $45.2 billion of exposure to overall residential mortgage-backed securities, which comprises 7% of MBIA’s insured portfolio, as of Sept. 30, 2007.

The triple-A credit rating of the bigger bond insurers is crucial because any demotion could lead to downgrades of the $2.4 trillion of municipal and structured bonds they guarantee. This could force banks to increase the amount of capital held against bonds and hedges with bond insurers – a worrying prospect at a time when lenders such as Citigroup and Merrill are scrambling to raise capital. Significant changes in counterparty strengths of bond insurers could lead to systemic issues. Warren Buffett’s Berkshire Hathaway set up a new bond insurer in December 2007 after the New York State insurance regulator pressed him to do so.

If credit insurers turn out to have inadequate reserves, the credit default swap (CDS) market may well seize up the same way the commercial paper market did in August 2007. The $45 trillion of outstanding CDS is about five times the $9 trillion US national debt. The swaps are structured to cancel each other out, but only if every counterparty meets its obligations. Any number of counterparty defaults could start a chain reaction of credit crisis.

The Financial Times reported that Jamie Dimon, chief executive of JPMorgan, said when asked about bond insurers: “What [worries me] is if one of these entities doesn’t make it … the secondary effect … I think could be pretty terrible.”

The Danger of High Leverage

The factor that has catapulted the subprime mortgage market into crisis proportion is the high leverage used on transactions involving the securitized underlying assets. This leverage multiplies profits during expansive good times and losses in during times of contraction.  By extension, leverage can also magnify insipid inflation tolerated by the Fed into hyperinflation.

As big as the residential subprime mortgage market is, the corporate bond market is vastly larger. There are a lot of shaky outstanding corporate loans made during the liquidity boom that probably could not be refinanced even in a normal credit market, let alone a distressed crisis. A large number of these walking-dead companies held up by easy credit of previous years are expected to default soon to cause the CLO valuations to plummet and CDS to fail.

Commercial real estate is another sector with disaster looming in highly leveraged debts. Speculative deals fueled by easy cheap money have overpaid massive acquisitions with the false expectation that the liquidity boom would continue forever. As the economy slows, empty office and retail spaces would lead to commercial mortgage defaults.

Emerging markets will also run into big problems because many borrowers in those markets have taken out loans denominated in foreign currencies collateralized by inflated values of local assets that could be toxic if local markets are hit with correction or if local currencies lose exchange value. The last decade has been the most profligate global credit expansion in history, made possible by a new financial architecture that moved much of the activities out of regulated institutions and into financial instruments traded in unregulated markets by hedge funds that emphasized leverage over safety. By now there are undeniable signs that the subprime mortgage crisis is not an isolated problem, but the early signal of a systemic credit crisis that will engulf the entire financial world.

The Myth of Global Over Saving By the Working Poor 

Both former Fed chairman Greenspan and his current successor Ben Bernanke have tried to explain the latest US debt bubble as having been created by global over-saving, particularly in Asia, rather than by Fed policy of easy credit in recent years. Yet the so-called global savings glut is merely a nebulous euphemism for overseas workers in exporting economies being forced to save to cope with stagnant low wages and meager worker benefits that fuel high profits for US transnational corporations.  This forced saving comes from the workers’ rational response to insecurity rising from the lack of an adequate social safety net. Anyone making around $1,000 a year and faced with meager pension and inadequate health insurance would be suicidal to save less than half of his/her income. And that’s for urban workers in China.  Chinese rural workers make about $300 in annual income. For China to be an economic superpower, Chinese wages would have to increase by a hundred folds in current dollars.

Yet these underpaid and under-protected workers in the developing economies are forced to lend excessive portions of their meager income to US consumers addicted to debt. This is because of dollar hegemony under which Chinese exports earn dollars that cannot be spent domestically without unmanageable monetary penalties. Not only do Chinese and other emerging market workers lose by being denied living wages and the financial means to consume even the very products they themselves produce for export, they also lose by receiving low returns on the hard-earned money they lend to US consumers at effectively negative interest rates when measured against the price inflation of commodities that their economies must import to fuel the export sector. And that’s for the trade surplus economies in the developing world, such as China. For the trade deficit economies, which are the majority in the emerging economies, neoliberal global trade makes old-fashion 19^th-century imperialism look benign.

Central Banking Supports Global Fleecing of the Poor

The role central banking in support of this systematic fleecing of the helpless poor everywhere around the world to support the indigent rich in both advanced and emerging economies has been to flood the financial market with easy money, euphemistically referred to as maintaining liquidity, and to continually enlarge the money supply by financial deregulation to lubricate and sustain a persistently expanding debt bubble. Concurringly, deregulated financial markets have provided a free-for-all arena for sophisticated financial institutions to profit obscenely from financial manipulation. The average small investor is effectively excluded reaping the profits generated in this esoteric arena set up by big financial institutions. Yet the investing public is the real victims of systemic risk. The exploitation of mortgage securitization through the commercial paper market by special investment entities (SIVs) is an obvious example.

When the Fed repeatedly pulls magical white rabbits from its black opaque monetary policy hat, the purpose is always to rescue overextended sophisticated institutions in the name of preserving systemic stability, while the righteous issue of moral hazard is reserved only for unwitting individual borrowers who are left to bear the painful consequences of falling into financial traps they did not fully understand, notwithstanding that the root source of moral hazard always springs from the central bank itself.

Local Governments versus Giant Financial Institutions

The city of Baltimore is filing suit against Wells Fargo, alleging the bank intentionally sold high-interest mortgages more to blacks than to whites - a violation of federal law. Cleveland is filing suit against major investment banks such as Deutsche Bank, Goldman Sachs, Merrill Lynch and Wells Fargo for creating a public nuisance by irresponsibly bought and sold high-interest home loans, resulting in widespread defaults that depleted the cities’ tax base and left entire neighborhoods in ruins.  The cities hope to recover hundreds of millions of dollars in damages, including lost taxes from devalued property and money spent demolishing and boarding up thousands of abandoned houses.  “To me, this is no different than organized crime or drugs,” Cleveland Mayor Frank Jackson said in an interview with local media. “It has the same effect as drug activity in neighborhoods. It's a form of organized crime that happens to be legal in many respects.”

The Baltimore and Cleveland efforts are believed to be the first attempts by major cities to recover social costs and public financial losses from the foreclosure epidemic, which has particularly plagued cities with significant low-income neighborhoods. Cleveland’s suit is more unique because the city is basing its complaints on a state law that relates to public nuisances. The suit also is far more wide-reaching than Baltimore’s in that instead of targeting the mortgage brokers, it targets the investment banking side of the industry, which feeds off the securitization of mortgages.

Greenspan Blames Market Euphoria, Third World Workers, but not the Fed 

Greenspan in his own defense describes the latest credit crisis as a result of a sudden “re-pricing of risk - an accident waiting to happen as the risk was under-priced over the past five years as market euphoria, fostered by unprecedented global growth, gained traction.” Greenspan spoke as if the Fed had been merely a neutral bystander, rather than the “when in doubt, ease” instigator that had earned its chairman wizard status all through the years of easy money euphoria.

The historical facts are that while the Fed kept short-term rate too low for too long, starting a downward trend from January 2001 and bottoming at 0.75% for the discount rate on November 6, 2002 and 1% for the Fed Funds rate target on June 25, 2003, long term rates were kept low by structured finance, a.k.a. debt securitization and credit derivatives, with an expectation that inflation would be perpetually postponed by global slave labor. The inflation rate in January 2001 was 3.73%. By November 2002, the inflation rate was 2.2%, while the discount rate was at 0.75%. In June 2003, the inflation rate was 2.11% while the Fed Funds rate target was at 1%. For some 30 months, the Fed provided the economy with negative real interest rates to fuel a debt bubble.  <>Greenspan blames “the Third World, especially China” for the so-called global savings glut, with an obscene attitude of the free-spending rich who borrowed from the helpless poor scolding the poor for being too conservative with money.

Yet Bank for International Settlements (BIS) data show exchange-traded derivatives growing 27% to a record $681 trillion in third quarter 2007, the biggest increase in three years. Compared this astronomical expansion of virtual money with China’s foreign exchange reserve of $1.4 trillion, it give a new meaning to the term: “blaming the tail for wagging the dog.” The notional value of outstanding over-the-counter (OTC) derivative between counterparties not traded on exchanges was $516 trillion in June, 2007, with a gross market value of over $11 trillion, which half of the total was in interest rate swaps. China was hardly a factor in the global credit market where massive amount of virtual money has been created by computerized trades.

Greenspan’s Belated Warning on Stagflation

In an article entitled Liquidity Boom and Looming Crisis that appeared in Asia Times on Line on May 9 2007, I warned: “The Fed’s stated goal is to cool an overheated economy sufficiently to keep inflation in check by raising short-term interest rates, but not so much as to provoke a recession. Yet in this age of finance and credit derivatives, the Fed’s interest-rate policy no longer holds dictatorial command over the supply of liquidity in the economy. Virtual money created by structured finance has reduced all central banks to the status of mere players rather than key conductors of financial markets. The Fed now finds itself in a difficult position of being between a rock and a hard place, facing a liquidity boom that decouples rising equity markets from a slowing underlying economy that can easily turn toward stagflation, with slow growth accompanied by high inflation.” Seven months after my article, on December 16, Greenspan warned publicly on television against early signs of stagflation as growth threatens to stall while food and energy prices soar.

A Crisis of Capital for Finance Capitalism

The credit crisis that was detonated in August 2007 by the collapse of collateralized debt obligations (CDOs) waged a frontal attack on finance institution capital adequacy by December. Separately, commercial and investment banks and brokerage houses frantically sought immediate injection of capital from sovereign funds in Asia and the oil states because no domestic investors could be found quickly. But these sovereign funds investments have reached US regulatory ceiling of 10% equity ownership for foreign governmental investors, before being subject to reviews by the inter-agency Committee on Foreign Investment in the US (CFIUS) that investigates foreign takeover of US assets.

Still, much more capital will be needed in coming months by these financial institutions to prevent the vicious circle of expanding liabilities, tightening liquidity conditions, lowering asset values, impaired capital resources, reduced credit supply, and slowing aggregate demand feeding back on each other in a downward spiral.  New York Federal Reserve President Tim Geithner warned of an “adverse self-reinforcing dynamic.”

Ambrose Evans-Pritchard of The Telegraph, who as a Washington correspondent gave the Clinton White House ulcers, reports that Anna Schwartz, surviving co-author with the late Milton Freidman of the definitive study of the monetary causes of the Great Depression, is of the view that in the current credit crisis, liquidity cannot deal with the underlying fear that lots of firms are going bankrupt. Schwartz thinks the critical issue is that banks and the hedge funds have not fully acknowledged who is in trouble and by how much behind the opaque fog that obscures the true liabilities of structured finance.

While the equity markets are hanging on for dear life with the Fed’s help through stealth inflation, the bond markets have collapsed worldwide, with dollar bond issuance falling to a stand still, euro bonds by 66% and emerging market bonds by 75% in Q3 2007. Lenders are simply afraid to lend and borrowers are afraid to take on more liabilities in an imminent economic slowdown. The Fed has a choice of accepting an economic depression to cut off stagflation, or ushering hyperinflation by flooding the market with unproductive liquidity. Insolvency cannot be solved by injecting liquidity without the penalty of hyperinflation.

Next: Central Banking Has a History of Always Failing to Stabilize Markets

Road to Hyperinflation is paved with Market Accommodating Monetary Policy

By
Henry C.K. Liu

Part I: A Crisis the Fed Helped to Create but Helpless to Cure

Part II: Central Banking History of Failing to Stabilize Markets http://www.henryckliu.com/page151.html

This article appeared in AToL on January 30, 2008



It has been forgotten by many that before 1913, there was no central bank in the United States to bail out troubled commercial and associated financial institutions or to keep inflation in check by trading employment for price stability. Few want inflation but fewer still would trade their jobs for price stability.

For the first 137 years of its history, the US did not have a central bank. The nation then was plagued with recurring business cycles of boom and bust. For the past 94 years that the Federal Reserve, the US central bank, has assumed the role of monetary guardian for the nation, recurring business cycles of boom and bust have continued, often with the accommodating participation of the Fed. Central banking has failed in its fundamental functions of stabilizing financial markets with monetary policy, succeeding neither in preventing inflation nor sustaining growth nor achieving full employment. Since the Fed was founded in 1913, the US inflation has registered 1,923%, meaning prices have gone up 20 times on average despite a sharp rise inproductivity.

For the 18 years (August 11, 1987 to January 31, 2006) of his tenure as chairman of the Fed, Alan Greenspan had repeatedly bought off the collapse of one debt bubble with a bigger debt bubble. During that time, inflation was under 2% in only two years, 1998 and 2002, both times not caused by Fed policy. Paul Volcker, who served as Fed Chairman from August 1979 to August 1987, had to raise both the fed funds rate and the discount to 20% to fight hyperinflation of 18% in 1980 back down to 3.66% in 1987, the year Greenspan took over the Fed just before the October 1987 crash when inflation rose to 4.53%.

Under Greenspan’s market accommodating monetary policy, US inflation reached 4.42% in 1988, 5.36% in 1989 and 6.29% in 1990. US inflation rate was moderated to 1.55% by the 1997 Asian financial crisis when Asian exporting economies devalued their currencies to lower their export prices, but Greenspan allowed US inflation rate to rise back to 3.76% by 2000.  The fed funds rate hit a low of 1.75% in 2001 when inflation hit 3.76%; it hit 1% when inflation hit 3.52% in 2004; and it hit 2.5% when inflation hit 4.69% in 3005. For those years, US real interest rate was mostly negative after inflation. Factoring in the falling exchange value of the dollar, the Fed was in effect paying US transnational corporate borrowers to invest in non-dollar markets, and paying US financial institution to profit from dollar carry trade, i.e. borrowing dollars at negative rates to speculate in assets denominated in other currencies with high yields.

Central Banks Prevent Global Market Corrections with Hyperinflation

In recent years, the US has been allowing the dollar to fall in exchange value to moderate the adverse effect of high indebtedness and use depressed wages, both domestic and foreign, to moderate US inflationary pressure. This trend is not sustainable because other governments will intervene in the foreign exchange market to keep their own currencies from appreciating against the dollar to remain competitive in global trade. The net result will be a moderating of drastic changes in the exchange rate regime but not a halt of dollar depreciation.  What has happened is a global devaluation of all currencies with the dollar as the lead sinking anchor in terms of purchasing power. The sharp rise of prices for assets and commodities around the world has been caused by the sinking of the purchasing power of all currencies. This is a trend that will end in hyperinflation while the exchange rate regime remains operational, particularly if central banks continue to follow a coordinated policy of holding up inflated asset and commodities prices globally with loose monetary policies, i.e. releasing more liquidity every time markets face imminent corrections.

Politics of Central Banking

The circumstances that created the political climate in the United States for the adoption of a central bank came ironically from internecine war on Wall Street that spread economic devastation across the nation during the recession of 1907-08, the direct result of one dominant money trust trying to cannibalize its competition.

In 1906, the powerful Rockefeller interests in Amalgamated Copper executed a plan to destroy the Heinze combination, which owned Union Copper Co. By manipulating the stock market, the Rockefeller faction drove down Heinze stock in Union Copper from $60 to $10. The rumor was then spread that not only Heinze Copper but also the Heinze banks were folding under Rockefeller pressure. J P Morgan joined the Rockefeller enclave to announce that he thought the Knickerbocker Trust Co would be the first Heinze bank to fail. Panicked depositors stormed the teller cages of Knickerbocker to withdraw their money. Within a few days the bank was forced to close its doors. Similar fear spread to other Heinze banks and then to the whole banking world. The crash of 1907 was on.

Millions of depositors were sold out penniless their savings wiped out by bank failures and homeowners rendered homeless by bank foreclosure of their mortgages. The destitute, the hungry and the homeless were left to fend for themselves as best they could, which was not very well. Money still in circulation was hoarded by those who happened to still have some, so before long a viable medium of exchange became practically non-existent in a dire liquidity crisis. The 1907 depression was much more severe for the average family than the one in 1930.

Many otherwise healthy businesses began printing private IOUs and exchanging them for raw materials as well as giving them to their remaining workers for wages. These “tokens” passed around as a temporary medium of exchange to keep the economy functioning minimally. At this critical juncture, J P Morgan offered to salvage the last operating Heinze bank (Trust Co of America) on condition of a fire sale of the valuable Tennessee Coal and Iron Co in Birmingham to add to the monopolistic US Steel Co, which he had earlier purchased from Andrew Carnegie.

This arrangement violated then existing anti-trust laws but in the prevailing climate of depression crisis, the proposed transaction was quickly approved by a thankful Washington. Morgan was also intrigued by the paper IOUs that various business houses were being allowed to circulate as temporary media of exchange. Using the argument of the need to create order out of monetary chaos, the same argument that Rockefeller used to build the Standard Oil Trust, Morgan persuaded Congress to let him put out $200 million in such “tokens” issued by one of the Morgan financial entities, claiming this flow of Morgan “certificates” would revive the stalled economy. The nominal GDP fell from $34 billion in 1907 to $30 billion in 1908 and did not recover to $34 billion until 1911, even with an average annual inflation rate of over 7%.

Getting Rich from Making Money

As these new forms of Morgan “money” began circulating, the public regained its “confidence” and hoarded money began to circulate again as well in anticipation of inflation. Morgan circulated $200 million in “certificates” created out of nothing more than his “corporate credit” with formal government approval. This is the equivalent of $100 billion in today’s money. It was a superb device to get fabulously rich by literally making money.

Eight decades later, GE Capital, the finance unit of the world’s largest conglomerate that incidentally also manufactures hard goods, did the same thing in the 1990s with commercial papers and derivatives to create hundreds of billions in profits. Soon, every corporation and financial entities followed suit and the commercial paper market became a critical component of the financial system. This was the market that seized in August 2007 that started the current credit crisis. “The commercial paper market, in terms of the asset-backed commercial paper market, is basically history,” said William H. Gross, chief investment officer of the bond management firm Pacific Investment Management Company, known as Pimco.

The commercial paper market historically was best known as an alternative market funding source for non-financial corporations, at times when bank loans were seen as too expensive or possibly not available due to tight monetary policy. Finance companies, especially those affiliated with major auto companies and well-known consumer-credit lenders have also issued paper tied to non-financial industrial entities.  In the mid-1990s, non-financial corporate issues were still nearly 30% of total paper outstanding.  This share began to drop precipitously just before the recession of 2001 and has stabilized but not recovered.  By March 2006, the non-financial segment constituted a mere 7.8% of the total, the lowest ever in the 37-year history of the data. Financial companies have also altered their approach to the market.  Some paper is still backed by companies’ general financial resources, but other commercial paper is backed by specific loans, including automobile and credit card debt and home mortgages. Most ominously, commercial paper is used to finance securitized credit instruments that move debt liabilities off the balance sheets of the borrowers.

Some conspiracy theorists assert that the seeds for the Federal Reserve System had been sown with the Morgan certificates. On the surface, J P Morgan seemed to have saved the economy - like first throwing a child into the river and then being lionized for saving him with a rope that only he was allowed to own, as some of his critics said. On the other hand, Woodrow Wilson wrote: “All this trouble [the 1907 depression] could be averted if we appointed a committee of six or seven public-spirited men like J P Morgan to handle the affairs of our country.” Both Morgan and Wilson were elite internationalists.

The House of Morgan then held the power of deciding which banks should survive and which ones should fail and, by extension, deciding which sector of the economy should prosper and which should shrink. The same power today belongs to the Fed whose policies have favored the financial sector at the expense of the industrial sector. At least the House of Morgan then used private money for its predatory schemes of controlling the money supply for its own narrow benefit. The Fed now uses public money to bail out the private banks that own the central bank in the name of preventing market failure.

The issue of centralized private banking was part of the Sectional Conflict of the 1800s between America’s industrial North and the agricultural South that eventually led to the Civil War. The South opposed a centralized private banking system that would be controlled by Northeastern financial interests, protective tariffs to help struggling Northeast industries and federal aid to transportation development for opening up the Midwest and the West for investment intermediated through Northeastern money trusts backed by European capital.

Money as Political Instrument

Money, classical economics’ view of it notwithstanding, is not neutral. Money is a political issue. It is a matter of deliberate choice made by the state with consequential implications in support of a strategic political and geopolitical agenda. In a democracy, that choice should be made by the popular will, rather than by a small select group of political appointees. The supply of money and its cost, as well as the allocation of credit, have direct socio-political implications beyond finance and economics. Policies on money reward or punish different segments of the population, stimulate or restrain different economic sectors and activities. They affect the distribution of political power. Democracy itself depends on a populist monetary policy.

Economist Joseph A Schumpeter (1883-1950) observed that in the first part of the 19th century, mainstream economists believed in the merit of a privately provided and competitively supplied currency. Adam Smith differed from David Hume in advocating state non-intervention in the supply of money. Smith, an early advocate of progressive taxation, argued that a convertible paper money could not be issued to excess by privately owned banks in a competitive banking environment, under which the Quantity Theory of Money is a mere fantasy and the Real Bills doctrine is reality. Smith never acknowledged or understood the business cycle of boom and bust. He denied its existence by proposing to forbid its emergence by the use of governmental powers. The policy of laissez-faire, or government non-intervention in trade, broadly attributed by present-day market fundamentalists to Adam Smith who himself never used the term, nor did any of his British colleagues, such as Thomas Malthus and David Ricardo, requires government intervention to be operative.

The anti-monopolistic and anti-regulatory Free Banking School found support in agrarian and proletarian mistrust of big banks and paper money. This mistrust was reinforced by evidence of widespread fraud in the banking system, which appeared proportional to the size of the institution. Paper money was increasingly viewed as a tool used by unconscionable employers and greedy financiers to trick working men and farmers out of what was due to them in a free market. A similar attitude of distrust is currently on the rise as a result of massive and pervasive corporate and financial fraud in the brave new world of banking fueled by structured finance in the under-regulated financial markets of the 1990s, though not focused on paper money as such, but on electronic money use in derivative transactions, which is paperless virtual money built on debt.

The $7 billion loss caused by alleged fraud committed by a low-level trader at Société Générale, one of the largest and most respected banks in France, was shocking not because it happened, but because for a whole year, the fraud was not discovered while the unauthorized trades were profitable. It would not be unreasonable for the counterparties that had suffered losses in these unauthorized but profitable trades to sue SoGen for recovery.

Andrew Jackson who in 1835, managed to reduce the federal debt to only $33,733, the lowest it has been since the first fiscal year of 1791, vetoed the bill to renew the charter of the Second Bank of the United States. In his farewell speech in 1837, Jackson addressed the paper-money system and its natural association with monopoly and special privilege, the way Dwight D Eisenhower in 1961 warned a paranoid nation gripped by Cold War fears against the domestic threat of a military-industrial complex at home. The value of paper, Jackson stated, “is liable to great and sudden fluctuations and cannot be relied upon to keep the medium of exchange uniform in amount.”

In his veto message, Jackson said the Bank needed to be abolished because it concentrated excessive financial strength in one single institution, exposed the government to control by foreign investors, served mainly to make the rich richer and exercised undue control over Congress. “It is to be regretted that the rich and powerful too often bend the acts of government to their selfish purposes,” wrote Jackson.  In 1836, Jackson issued the Specie Circular which required government lands to be paid in “specie” (gold or silver coins), which caused many banks that did not have enough specie to exchange for their notes to fail, leading to the Panic of 1837 as the bursting of the speculative bubble threw the economy into deep depression. Jacksonian Democrat partisans to this day blame the severe depression on bank irresponsibility, both in funding rampant speculation and by abusing paper money issuance to cause inflation. It remains to be seen if the credit crisis of 2007 would cause the elections of 2008 to revive the Jacksonian populism that founded the modern Democrat Party.

Jackson’s farewell message read: “....The planter, the farmer, the mechanic, and the laborer all know that their success depends upon their own industry and economy and that they must not expect to become suddenly rich by the fruits of their toil. Yet these classes of society form the great body of the people of the United States; they are the bone and sinew of the country; men who love liberty and desire nothing but equal rights and equal laws and who, moreover, hold the great mass of our national wealth, although it is distributed in moderate amounts among the millions of freemen who possess it. But, with overwhelming numbers and wealth on their side, they are in constant danger of losing their fair influence in the government, and with difficulty maintain their just rights against the incessant efforts daily made to encroach upon them.”

It is clear that the developing pains of the credit crisis of 2007 is not evenly borne by all, with a select few who had caused the crisis walking away with million in severance compensation and the few who are selected to restructure the financial mess no doubt will gain millions while the mass of victims are losing homes, jobs and pensions, with no end in sight. The trouble with unregulated finance capitalism is not just that it inevitably produces boom and busts, but that the gains and pains are distributed in obscene uneven proportions.

Merit of Central Banking Overstated

The monetary expansion that preceded and led to the recession of 1834-37 did not come from a falling bank reserve ratio, but rather from the bubble effect of an inflow of silver into the United States in the early 1830s, the result of increased silver production in Mexico, and also from an increase in British investment in the United States. Thus a case could be made that the power of central banking in causing or preventing recessions through management of the money supply is overstated and oversimplified.

Libertarians hold the view that the state had neither the right nor the skill to regulate any commercial transactions freely entered into between consenting individuals, including the acceptance of paper currency. Thus all legal tenders, specie or not, are government intrusions. Yet the key words are “freely entered into”, a condition most markets do not make available to all participants. Market conditions invariably compel participants to enter into disadvantaged transactions for lack alternatives because of uneven market power.

For example, family must buy food regardless of price set by agribusiness, since inflation is not a matter that the average consumer can control.  When it comes to money, a medium of exchange based on bank liabilities and a fractional reserve system and/or government taxing capacity is essential to an industrializing economy. But today, when bank liability can be masked by off-balance sheet securitization, the credibility of money is threatened. Back in 1837, instead of eliminating abuse of the fractional reserve system, the hard-money advocates had merely unwittingly removed a force that acted to restrain it.

After 1837, the reserve ratio of the banking system was much higher than it had been during the period of the Second Bank of the United State (BUS2). This reflected public mistrust of banks in the wake of the panic of 1837 when out of 850 banks in the United States, 343 closed entirely, 62 failed partially. This lack of confidence in the paper-money system led to the myth that it could have been ameliorated by central-bank liquidity, which would have required a lower reserve ratio, more availability of credit and an increase of money supply during the 1840s and 1850s. The myth contends that with central banking, the evolution of the US banking system would have been less localized and fragmented in a way inconsistent with large industrialized economics, and the US economy would have been less dependent on foreign investment. This did not happen even after 1913 because central banking was genetically disposed to favor the center against the periphery, which conflicted with democratic politics.

President Martin Van Buren was harshly judged and lost reelection because of his ideologically commitment of keeping the government out of banking regulation. Many economic historians feel Van Buren extended the effects of the Panic which lasted until 1843, while others consider his approach to have minimized potentially destructive interference.

This problem continues today with central banking in a globalized international finance architecture. It remains a truism that it is preferable to be self-employed poor than to be working poor. Thus economic centralism will be tolerated politically only if it can deliver wealth away from the center to the periphery to enhance economic democracy. Yet central banking in the past two decades has centralized wealth. Central banking carries with it an institutional bias against economic nationalism or regionalism as well as a structural bias in favor of economic centralism. It obstructs the delivery of wealth created at the periphery back to the periphery.

After 1837, the US federal government had no further connection with the banking industry until the National Bank Act of 1863. Although the Independent Treasury that operated between 1846 and 1921, to pay out its own funds in specie money and be completely independent of the banking and financial system of the nation, did restrict reckless speculative expansion of credit, it also created a new set of economic problems. In periods of prosperity, revenue surpluses accumulated in the Treasury, reducing hard-money circulation, tightening credit, and restraining even legitimate expansion of trade and production. In periods of depression and panic, on the other hand, when banks suspended specie payments and hard money was hoarded, the government's insistence on being paid in specie tended to aggravate economic difficulties by limiting the amount of specie available for private credit. The Panic of 1907 exposed the inability of the Independent Treasury to stabilize the money market and led to the passage of the Federal Reserve Act in 1913, which allowed the Federal Reserve Bank, a private corporation, to coin money and regulate the value of the common currency.

The Right to Make Money Taken From the People

The 1863 US National Bank Act amended and expanded the provisions of the Currency Act of the previous year. Any group of five or more persons with no criminal record was allowed to set up a bank, subject to certain minimum capital requirements. As these banks were authorized by the federal government, not the states, they are known as national banks, not to be confused with a national bank in the Hamiltonian sense. To secure the privilege of note issue they had to buy government bonds and deposit them with the comptroller of the currency.

When the Civil War began in 1861, newly installed President Abraham Lincoln, finding the Independent Treasury empty and payments in gold having to be suspended, appealed to the state-chartered private banks for loans to pay for supplies needed to mobilize and equip the Union Army. At that time, there were 1,600 private banks chartered by 29 different states, and altogether they were issuing 7,000 different kinds of banknotes.

Lincoln immediately induced the Congress to authorize the issuing of government notes (called greenbacks) promising to pay “on demand” the amount shown on the face of the note, not backed by gold or silver. These notes were issued by the US government as promissory notes authorized under the borrowing power specified by the constitution. The total cost of the war came to $3 billion. The government raised the tariff, imposed a variety of excise duties, and imposed the first income tax in US history, but only managed to collect a total of $660 million during the four years of Civil War. Between February 1862 and March 1863, $450 million of paper money was issued. The rest of the cost was handled through war bonds, which were successfully issued through Jay Cooke, an investment banker in Philadelphia, at great private profit. The greenbacks were supposed to be gradually turned in for payment of taxes, to allow the government to pay off these greenback notes in an orderly way without interest. Still, during the gloomiest period of the war when Union victory was in serious doubt, the greenback dollar had a market price of only 39 cents in gold.

Undoubtedly these greenback notes helped Lincoln save the Union. Lincoln wrote: “We finally accomplished it and gave to the people of this Republic the greatest blessing they ever had - their own paper to pay their own debts.” The importance of the lesson was never taught to Third World governments by neo-liberal monetarists.

In 1863, Congress passed the National Bank Act. While its immediate purpose was to stimulate the sale of war bonds, it served also to create a stable paper currency. Banks capitalized above a certain minimum could qualify for federal charter if they contributed at least one-third of their capital to the purchase of war bonds. In return, the federal government would give these banks national banknotes to the value of 90 percent of the face value of their bond holdings. This measure was profitable to the banks, since with the same initial capital, they could buy war bonds and collect interest from the government, and at the same time put the national banknotes in circulation and collect interest from borrowers. As long as government credit was sound, national banknotes could not depreciate in value, since the quantity of banknotes in circulation was limited by war-bond purchases. And since war bonds served as backing for the notes, the effect was to establish a stable currency.

The system did not work perfectly. The currency it provided was not sufficiently elastic for the needs of an expanding economy. As the government redeemed war bonds, the quantity of notes in circulation decreased, causing deflation and severe hardship for debtors. Money seemed to be concentrated in the Northeast, while Western and Southern farmers continued to suffer chronic scarcity of cash and credit, not unlike current conditions faced by Third World debtor economies.

After the Civil War, the Independent Treasury continued in modified form, as each administration tried to cope with its weaknesses in various ways. Treasury secretary Leslie M Shaw (1902-07) made many innovations; he attempted to use Treasury funds to expand and contract the money supply according to the nation’s credit needs. The panic of 1907, however, finally revealed the inability of the system to stabilize the money market; agitation for a more effective banking system led to the passage of the Federal Reserve Act in 1913. Government funds were gradually transferred from sub-treasury "vaults" to district Federal Reserve Banks, and an act of Congress in 1920 mandated the closing of the last sub-treasuries in the following year, thus bringing the Independent Treasury System to an end.

Populism and Monetary Politics

John P Altgeld, a German immigrant populist who became the Democratic governor of Illinois in 1890, attacked big corporations and promoted the interest of farmers and workers, to give the state an able, courageous and progressive administration. The question of currency was central to the US populist movement. Farmers knew from first-hand experience that the fall in farm prices was caused by the policy of deflation adopted by the federal government after the Civil War and only ineffectively checked by the Bland-Allison Act of 1878, coining silver at a fixed ratio of 16:1 with gold, and the Sherman Silver Purchase Act of 1890. The Treasury’s redemption of silver with gold increased the value of money and deflated prices.

Despite the rapid growth of business, the government engineered a sharp fall in the per capita quantity of money in circulation. The National Bank Act of 1863 also limited banks’ notes to the amount of government bonds held by banks. The Treasury paid down 60% of the national debt and reduced considerably the monetary base, not unlike the bond-buyback program of the Treasury in 1999. To farmers, it was unfair to have borrowed when wheat sold for $1 per bushel and to have to repay the same debt amount with wheat selling for 63 cents a bushel, when the fall in price was engineered by the lenders. To them, the gold standard was a global conspiracy, with willing participation by the US Northeastern bankers - the money trusts who were agents of international finance, mostly British-controlled.

President Grover Cleveland, despite winning the 1892 election with populist support within the Democratic Party, gave no support to populist programs. Cleveland saw his main responsibilities as maintaining the solvency of the federal government and protecting the gold standard. Declining business confidence caused gold to drain from the Treasury at an alarming rate. The Treasury then bought gold at high prices from the Morgan and Belmont banking houses at great profit to them. Populists saw this effort to save the gold standard as a direct transfer of wealth from the people to the bankers and as the government’s capitulation to international finance capital. Cleveland even sent federal troops to Illinois to break the railroad strike of 1894, over the vigorous protest of governor Altgeld.

The election of 1896 was about the gold standard. Cleveland lost control of the Democratic Party, which nominated 36-year-old William Jenning Bryan, who declared in one of the most famous speeches in US history (though mostly shunned these days): "You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold." The banking and industrial interests raised $16 million for William McKinley to defeat Bryan, who suffered a defeat worse than Jimmy Carter’s by Ronald Reagan. With the McKinley victory, the Hamiltonian ideal was firmly ordained, but with most of its nationalist elements sanitized and replaced with a new finance internationalism. It was not dissimilar to the Reagan victory over Carter in 1980 in many respects.

The 16th amendment to the US constitution calling for a “small” income tax was enacted to compensate for the anticipated loss of revenue from the lowering of tariffs from 37 to 27% as authorized by the Underwood Tariff of 1913, the same year the Federal Reserve System was established. “Small” now translates into an average of 50% with federal and state income taxes combined. Free trade is only free in the sense that it is funded by the income tax.

The supply-side argument that corporate tax cuts stimulate economic growth only holds if the at least half of the benefits of the tax cut are channel toward rising wages, instead of higher return on capital with the additional benefit of lower capital gain tax. Thus a case can be made to couple all corporate tax cuts with an index on wage rise to match or exceed corporate earnings. One of the reasons why strong corporate earnings have not help the current credit crisis can be traced to the disproportional rise in equity prices having come from stagnant wages in the same corporations.

The Glass-Owen Federal Reserve Act was passed in December 1913 under the administration of President Woodrow Wilson. The system set up five decades earlier by the National Bank Act of 1863 had two major faults: 1) the supply of money had no relation to the needs of the economy, since the money in circulation was limited by the amount of government bonds held by banks; and 2) each bank was independent and enjoyed no systemic liquidity protection. These problems were more severe in the South and the West, where farmers were frequently victimized by bank crises often created by Northeastern money trusts to exploit the seasonal needs of farmers for loans. To this day, the Fed operates a seasonal discount rate to handle this problem of farm credit.

The Northeastern money elite in 1913 wanted a central bank controlled by bankers, along Hamiltonian lines, but internationalist rather than nationalist to make the US an global financial powerhouse. But the Wilson administration, faithful to Jacksonian tradition despite political debts to the moneyed elite, insisted that banking must remain decentralized, away from the control of Northeastern money trusts, and control must belong to the national government, not to private financiers with international links, despite the internationalist outlook of Wilson. Twelve Federal Reserve Banks were set up in different regions across the country, while supervision of the whole system was entrusted to a Federal Reserve Board, consisting of the Treasury secretary, the comptroller of the currency and five other members appointed by the president for 10-year terms.

All nationally chartered banks were required and state-chartered banks were invited to be members of the new system. All private banknotes were to be replaced by Federal Reserve notes, exchangeable at regional Federal Reserve Banks not only for bonds or gold, but also for top-rated commercial paper, with the hope of causing the money supply to expand and contract along with the volume of business. With the reserves of all banks deposited with the Federal Reserve, systemic stability was supposed to be assured. Unfortunately, systemic stability has been an elusive objective of the Fed throughout its history of 94 years, largely due to the Fed fixation on the market rather than the economy. To the Fed’s thinking, even today, the market drives the economy, not the other way around. Take care of the market, and the economy will take care of itself. Unfortunately for the Fed, this fixation has been proven wrong throughout history. The market is but a gauge on the economy. If the economy is running empty, fixing the gauge does not fix the real problem.

The Fed’s Ineffectual Response to the August 2007 Credit Crisis

The equity market’s decade-long joy ride on the Fed’s easy money policy came abruptly to an end in August 2007. Having lowered the discount rate 50 basis points to 5.75% but kept the Fed Funds rate target unchanged at 5.25% on August 17 in response to the outbreak of the credit crisis, which the Fed adamantly but mistakenly thought to be containable, the Federal Open Market Committee (FOMC) was forced on September 18 to again lower the discount rate another 50 basis point to 5.25% and the fed funds rate target 50 basis points to 4.75% as the credit market continued to deteriorate. Six weeks later, on October 31, 2007, the FOMC, trying to correct a massive credit market failure, once again lowered the discount rate another 25 basis points to 5% and the fed funds rate target another 25 basis points to 4.5% to try to inject liquidity into the severely distressed banking system.

In an accompanying statement on October 31, the Fed continued to paint a comforting picture that economic growth was solid in the third quarter of 2007, and strains in financial markets had eased somewhat on balance since August.  However, the Fed qualified its denial by saying: “the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction.” That action, combined with the policy action taken in September, was expected “to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.”

By November 27, the DJIA intraday low had dropped 1,000 points to 12,711.98 from the October 31 intraday low of 13,711.59, having reached an intraday high of 14.168.51 on October 12. Market anticipation of more Fed interest rate cuts to lift the market pushed the DJIA back up to 13,727.03 by December 11, on which day a panicked Fed again lowered the discount rate by 25 basis points to 5.75% and the fed funds rate target by 25 basis points to 4.25%. A disappointed market which had expected a 50 basis point cut saw the DJIA drop 295 points to close at 13,432.77.

The Fed was reduced to playing short-term yo-yo with interest rates driven by the stock market at the expense of its mandate to guard against long-term inflation. The Bureau of Labor Statistics (BLS) reported that the Headline Consumer Price Index (HCPI) for November 2007 was 4.3%, higher than November 2006, and 5 basis points higher than the Fed Funds rate target of 4.25%.

Fed Interest Rate Cuts Puts Downward Pressure on the Dollar

The Fed’s interest rate actions put continued downward pressure on the both the exchange rate and the real purchasing power of the dollar, thus further increasing inflation in import and domestic product prices, especially oil for which the US is both an importer and a producer. January oil price futures for April 2008 delivery jumped $1.35, to $88.75 a barrel. Since April 2006, core inflation has remained within the 2.2 - 2.3% range, higher than the unofficial targeted inflation rate of 1.6% to 1.9%. This hampers the Fed’s ability to lower interest rates further without unleashing inflation down the road.

Core and Headline Inflation

For the typical household, the total or headline inflation, which includes volatile food and energy price components, is what counts because headline inflation measures the rate at which the cost of living is rising against relatively stagnant household income. A high headline inflation rate relative to income growth causes household standard of living to fall.

For the purpose of calibrating monetary policy, however, the Fed focuses on the core rate of inflation: the total excluding food and energy prices, on account that the core is less volatile and is deemed a better reflection of the interplay of supply and demand in domestic product markets. Thus, the core traditionally is a better gauge of the underling rate of inflation in the absence of external supply shocks.

By contrast, food and energy prices can be extremely volatile from month to month due to temporary supply disruptions related to weather or to political crises. In those instances, headline inflation tends to be less representative of the underlying rate of inflation. Headline inflation has relatively minor macroeconomic impact; it tends to shift revenue from one sector to another. When oil prices rise, oil company revenue increases while consumer expenditure rises. The net result is a higher GDP figure but not necessarily a larger economy. Yet this rationale is less operative in the current situation where both energy and food prices have risen dramatically with volatility along an upward curve and imported oil payment has become a major item in the US trade deficit.

The historical record of the US economy is that headline and core inflation have averaged about the same over the long run. Over the past two decades, annual inflation as measured by the Personal Consumption Expenditure (PCE) deflator averaged 2.6%, while price increases as measured by the core PCE deflator averaged 2.5%. Data from the past ten years pose a challenge to the rationale for focusing on the core. Over that period, crude oil prices have been volatile, rising from below $10 per barrel in early 2000 to near $100 currently. Food prices and that of other commodities are also rising at an above normal rate. Such rise is no longer expected to be temporary. They tend to stay high for long periods because of the long-term decline of the dollar, which has become the main factor behind global hyperinflation trends. Thus even if the headline inflation rate eventually moderates from month to month, prices can stay high relative to income. Inflation readings from price levels independent of income levels are not informative on the health of the economy.

Readings on core inflation were interpreted by the Fed as having improved modestly in October 2007, but increases in energy and commodity prices in the second half of the year, among other factors, might put “renewed upward pressure on inflation.”  In that context, the FOMC judged that “some inflation risks remained, and it would continue to monitor inflation developments carefully.” The FOMC, after its October 31, 2007 action, judged “the upside risks to inflation roughly balance the downside risks to growth.”  The Committee would “continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.”

The single dissenting vote against the FOMC easing action was Thomas M. Hoenig, who argued for no cuts in the federal funds rate at the meeting. In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 5%.  In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Richmond, Atlanta, Chicago, St. Louis, and San Francisco.

Market Disappointment

On December 11, 2007, the Fed again cut the discount rate at which it lends directly to banks by 25 basis points to 4.75%, and the Fed Funds rate 25 basis points to 4.25%, halving the normal interest penalty on discount window. The market was visibly disappointed. US stocks fell sharply after the central bank cut the Fed Funds rate by only 25 basis points to 4.25% rather than the expected 50 basis points, and the market interpreted Fed language as failing to offer a clear signal of more cuts to come. The DJIA dropped 295 points to close at 13,432.77. The S&P 500 closed down 2.5% at 1,477.65, after being up 0.4% before the decision was released. Still, the yield on the two-year Treasury note fell to 2.92%, down from 3.14%, exerting downward pressure on the dollar. By January 8, 2008, the DJIA had fallen 843 points to 12,589.07.

The Fed said the deterioration in financial market conditions had “increased the uncertainty surrounding the outlook for economic growth and inflation.” But while it dropped its assessment that the risks to growth and inflation are “roughly balanced”, the Fed did not say that it now believed the risks to growth outweigh the risks to inflation. It offered no assessment of the balance of risks, saying it would act “as needed” to foster price stability and sustainable economic growth. This formula in effect meant the Fed was keeping its options open pending incoming data which are notoriously inaccurate and inevitably have to be revised in subsequent months.

Some market participants still inferred a willingness on the part of the Fed to consider future rate cuts, but the signal was weaker than many had expected. This reflected the fact that the Fed remained more concerned about the risks to inflation than most market participants who are more concerned with short-term profitability than the long-term health of the economy.

Once market sentiment starts to turn negative and more market participants anticipating a slowing economy if not a recession, market dynamics will shift the smart money toward new profit opportunities, such as going short on shares that depend on growth and going long on shares that will flourish in a recession. This will exert further negative pressure on the market in a self-reinforcing downward spiral.

Also not mentioned was the effect of further interest rate cuts would have on the exchange value of the dollar which had been falling, particularly against the euro, due to ECB reluctance to lower euro interest rates. The Fed is always cautious regarding pronouncement on the dollar’s exchange rate because that is the exclusive mandate of the Treasury which the Fed is required by law and constitution to support as a matter of national economic security.

Rise of the Euro

The International Monetary Fund reports that the euro’s share of known foreign exchange holdings rose to 26.4% in the third quarter of 2007, reflecting its increasing strength in foreign exchange markets. That was up from 25.5% in the previous three months and from 24.4% in the third quarter of 2006. The dollar’s share of known official foreign reserves, calculated in dollar terms, fell to 63.8% in the third quarter, down from 66.5% in the same three months of 2006. The trend of rising preference of the euro will strengthen the illusion held by European policymakers that the euro is maturing into a significant rival to the dollar while in fact the euro remains only a derivative currency of the dollar. The euro has been losing purchasing power along with the dollar, and the rise in its exchange value against the dollar merely signifies that the euro is depreciating at a slightly slower rate than the dollar. Dollar hegemony is a geopolitical phenomenon with a financial dimension, by virtue of the fact that all key commodities are denominated in dollars.  When the European Central Bank (ECB) intervenes to halt the rise in exchange value of the euro, it in effect accelerates the decline of the euro’s purchasing power. The same holds true for the Japanese yen or the Chinese yuan.

The Fed said on December 11, 2007 that “incoming information suggests that economic growth is slowing” reflecting an “intensification of the housing correction” and “some softening in business and consumer spending.” It acknowledged that “strains in financial markets have increased in recent weeks”. However, the US central bank still had made almost no changes to its cautionary language on inflation, reiterating that “energy and commodity prices, among other factors, may put upward pressure on inflation.”

Six weeks later, on January 22, in response to sharp declines in all markets around the world from the bursting of  the debt bubble, the Fed reversed itself diametrically and dramatically to announce a cut of 75 basis points of the fed funds rate target to 3.50%, throwing inflation concern to the wind. Yet the DJIA closed on January 22, 2008 at 11,973.06, down 126.24 points, or 1.04% from the previous Friday, but still higher than the October 17, 2006 close of 11,950.02, and 4,586.79 points, or 63% higher than the October 9, 2002 close of 7,286.27. Evidently, the Fed cast a visible vote for inflation to sustain the bursting debt bubble.

Fed Introduces Discount Loan Auction to Reduce Stigma

The Fed is not expected to eliminate the discount rate borrowing penalty altogether because such a step would allow a large number of small banks to obtain funds at less than their usual spread over the fed funds rate, and would complicate efforts to manage the fed funds rate through the open market. At the same time, the Fed was considering ways to try to reduce the “stigma” associated with using the discount window for the big banks, in order to make it more effective as a backstop to the money markets.

As a solution, the Fed overhauled the way it provides liquidity support to financial markets, following a negative market reaction to the timid December 11 interest rate cut. The overhaul took the shape of a new liquidity facility that will auction loans to banks. This would allow the Fed to provide liquidity directly to a large number of financial institutions against a wide range of collateral without the stigma of its existing discount window loans. The idea is that this would ease severe strains in the market for interbank loans, and help restore more normal conditions in credit markets generally as banks were getting reluctant to lend to each others for fear of counterparty default.

In a speech in early December, Fed vice-chairman Donald L. Kohn said “the effectiveness of the direct lending operation was still being undermined by banks’ fear that using it would be seen as a sign that they needed emergency funds. The problem of stigma is even greater in the UK where, following the Northern Rock debacle, banks are afraid of tapping funds from the Bank of England.” 

Kohn said all central banks – not just the Fed – had to find new ways to ensure that their liquidity support facilities remained effective in times of crisis. “Making the Fed discount window more usable is particularly important because all banks can pledge a wide range of securities in return for cash at this facility. Only a small number of primary dealers can access cash from the Fed through its main market liquidity facility – open market operations to control the fed funds rate – and the list of collateral that can be pledged is much narrower,” Kohn said.

Coordinated Effort by Central Banks

Euro money market rates tumbled after the European Central Bank (ECB) injected an unprecedented $500 billion equivalent into the banking system on December 18, 2007 as part of a global effort to ease gridlock in the credit market. The amount banks charge each other for two-week loans in euros dropped a record 50 basis points to 4.45%. The rate had soared 83 basis points in the previous two weeks as banks hoarded cash in anticipation of a squeeze on credit through year-end. The ECB loaned a record 348.6 billion euros ($501.5 billion) for two weeks at 4.21% on that day, almost 170 billion euros more than it estimated was needed. Bids were received from 390 banks, ranging from 4% to 4.45%.

A coordinated effort by central bankers helped the credit markets and specifically the London Interbank Offer Rate (LIBOR) which had drifted to an 85-basis-point spread from the fed funds rate. That widening spread was a clear signal of distress in the credit markets. It showed that banks were risk averse in their lending habits and were reluctant to lend to each other out of concern for counterparty risk.  Getting LIBOR back in line, within 10-12 basis points of the fed funds rate historically, was a top priority to soothing the pain in the credit markets.  The Financial Times quoted Goldman Sachs economist Erik Nielson: “This is basically Father Christmas to those who have access to central bank funds]. They are bailing out people who have not really adjusted their balance sheets to the new reality.”

Fighting Deflation with Negative Interest Rates

Low and frequently negative real interest rates over long periods of time had created the debt bubble, the bursting of which resulted in the credit crisis of August 2007. Central banks are now responding to the bursting of the debt bubble by cutting interest rates yet again. Central banks seem to be letting unreliable incoming raw economic data on the previous month to drive interest rate policy which at best can only have longer term effect. The addiction to negative real interest rate to sustain the debt bubble will eventually lead to a toxic financial overdose.

Lessons of the Great Depression of the 1930s and the protracted Japanese recession of the 1990s have left all central banks with a phobia about asset deflation, against which monetary policy of zero nominal interest rate can have little effect. Since nominal rates cannot go below zero, deflation, or negative inflation, implies positive real interest rates even as nominal rate is zero, causing central banks to lose their ability to provide needed economic stimulus by monetary means. In a deflationary environment, borrowers will find it more costly to repay loans of even zero interest rate. The history lesson learned by central bankers is that when an asset-price bubble bursts with threats of deflationary recession, monetary policy therapy has to be dramatic, timely and visible to be effective.

Next: Inflation Targeting